Trading Strategies Chapter 11 1 Disclaimer Some parts

Trading Strategies Chapter 11 1

Disclaimer! Some parts of the slides have been taken from different sources and then have been cutomized. thereafter. No plagiarism applies! 2

Basic financial derivatives Options European Call price increases in 1. 2. 3. 4. 5. Current stock price (S 0) Maturity (T) Risk free rate (r) Volatility (Risk) Expected Cost If these factors goes up call price go up Call price decreases in 1. Strike Price (K) 2. Expected Dividend (I) 3 If price of these factors goes up call price goes down

Basic financial derivatives Options Call: k increase price of the call option decrease K increase price of the put option increase European Put S 0 is spot price Put price increases in 1. 2. 3. 4. Strike Price (K) Expected Dividend (I) Maturity (T) Volatility (Risk) Put price decreases in 1. Current stock price (S 0) 2. Risk free rate (r) 3. Expected cost 4

Some drawing rules for options. 1. Left-Right: Call option starts from left but put option starts from right? 2. Up-Down: long option starts from below zero but short option starts from above zero? 3. The difference between ST line and the part of the option line parallel to ST is the option premium, option price or option cost. 4. K is always on the ST line. 5. If there are more than on K’s on ST line, then any K on the right is bigger than any K on the left. 6. For call option, higher the K lower will be the premium. (inverse relation) 7. For put option, higher the K higher will be the premium. (Direct relation) 5

General Questions about a Strategy. 1. 2. 3. 4. 5. 6. Name of The Strategy. In what situation The Strategy is used? How many positions The Strategy involves? What are the long and short positions in The Strategy ? Drawing the graph of The Strategy. On the basis of given data, calculating the payoff and net gains/losses of The Strategy. 7. Drawbacks of The Strategy. 6

Stock + Option Positions • Covered call • In what situation covered call option is used? • Long stock+short call is called covered call and is used to protect investor for a sharp rise in the stock price. • Reverse Covered call • In what situation reverse covered call option is used? • short stock+ long call is called reverse covered call and is used to protect investor for a sharp fall in the stock price. 7

Stock + Option Positions • Protective Put • In what situation protective put option is used? • Long stock+ Long put is called protective put and is used to protect investor for a sharp rise in the stock price. • Reverse Protective Put • In what situation reverse protective put option is used? • short stock + short put is called reverse protective put and is used to protect investor for a sharp fall in the stock price. 8

Positions in an Option & the Underlying (Figure 11. 1, page 257) Use when there is a sudden rise in prices Red (strategy payoff, portfolio payoff) = Sum of long stock (payoff 1) + option (payoff 2) Call + stock will make you a put option Has a long call position, he expects price to go up. But suddenly price goes down. 2 positions (short call and option) Put + stock will make you a call option the red line when he expects price to decrease and took long put but sudden increase in prices When expects price to not fall 9

Answering Strategy Q in Exam • I will be looking for • Each position graph in BLACK • Net pay off graph in RED • Reason of strategy construction lies in Red 10

Covered Call Covered call 11

Covered Call: Portfolio Pay off

Rules from Chapter 1 1. 2. 3. 4. 5. Exercising option means buying and selling at ‘K’. Not exercising option means buying and selling at ‘K’. When option is not exercised it means long loses ‘f’ and short gains ‘f’. Call option is exercised only if ST > K. Put option is exercised only if ST<K. 13

Covered Call: Portfolio Pay off

Reverse Covered Call 15

Reverse Covered Call: Portfolio Pay off

Reverse Covered Call: Portfolio Pay off

Covered Call: Question Example Suppose that a speculator does not expect a price rise in the underlying stock and wants to capitalize on his expectations. At the same time, he wants to protect against price risk. What kind of strategy should he use? It is a covered call Does not expect price rise take short call Expect price rise long call

Reverse Covered Call: Question Example Suppose that a speculator expects a price rise in the underlying stock and wants to capitalize on his expectations. At the same time, he wants to protect against price fall risk. What kind of Reverse cover call strategy should he use?

Bull Spread Using Calls (Figure 11. 2, page 258) Bull When open price are smaller than closing price K 1 <K 2 LONG WILL BE AT K 1 K 2 will be short Strategy: Bull spread Either call or put. When you use both calls, there will be one short and one long Bear when opening price are greater than closing price K 1 <K 2 LONG WILL BE AT K 2 (higher K) K 1 will be short Strategy: bear spread Either call or put. When you use both calls, there will be one short and one long 20

Bull Spread Using Calls (Figure 11. 2, page 258) 21

General Questions about a Strategy. 1. Name of The Strategy. Bull Spread 2. In what situation The Strategy is used? When investor compromise on upside gain to cover downside risk during bull market situation. When the underlying asset closes at the higher strike price at expiration, a bullish spread maximizes the profit on the underlying asset. 3. How many positions The Strategy involves? TWO 4. What are the long and short positions in The Strategy ? One long call/put (with lower K) and one short call/put (with higher K) 5. Drawing the graph of The Strategy. As per slide. 6. On the basis of given data, calculating the payoff and net gains/losses of The Strategy. 7. Drawbacks of The Strategy. Limited gain and limited loss. 22

Bull Spread Using calls

Understanding Bull spread 1. 2. 3. 4. 5. 6. 7. Lower K (K 1) will be long For call higher premium comes with lower strike and vice-versa. For put higher premium comes with higher strike and vice-versa. Pay off long call = ST – K – f Pay off short call = K - ST + f Pay off long put = K - ST - f Pay off short put = ST – K + f 24

Bull Spread Using Calls Option ST Position Long call $35 Short call $35 Strategy cost Strategy Pay off K $20 $25 f (premium, Net Pay price, value) off -$4 $11 $3. 8 -$6. 2 -4+3. 8=-$0. 2 $4. 8 Investor will buy call option with strike price $20 by paying option price of $4 and sell a call option with strike price $25 by receiving an option price of $3. 8.

Bull Spread Using Puts Figure 11. 3, page 259 Profit K 1 K 2 ST 26

Example: Bull Spread Using Puts 27

Bull Spread Using Puts Option ST Position Long put $45 Short put $45 Strategy cost Strategy Pay off K $40 $50 f (premium, Net Pay price, value) off -$1. 5 $2. 0 -$3. 0 -1. 5+2. 0=$0. 5 -$4. 5 Investor will buy a put option with strike price $40 by paying option price of $1. 5 and sell a put option with strike price $50 by receiving an option price of $2. 0.

General Questions about a Strategy. 1. Name of The Strategy. Bear Spread 2. In what situation The Strategy is used? When investor compromise on downside gain to cover upside risk during bear market situation. When the underlying asset closes at the lower strike price at expiration, a bearish spread maximizes the profit on the underlying asset. 3. How many positions The Strategy involves? TWO 4. What are the long and short positions in The Strategy ? One long call/put (with higher K) and one short call/put (with lower K) 5. Drawing the graph of The Strategy. As per slide. 6. On the basis of given data, calculating the payoff and net gains/losses of The Strategy. 7. Drawbacks of The Strategy. Limited gain and limited loss. 29

Understanding Bear spread 1. 2. 3. 4. 5. 6. 7. Higher K (K 2) will be long For call higher premium comes with lower strike and vice-versa. For put higher premium comes with higher strike and vice-versa. Pay off long call = ST – K – f Pay off short call = K - ST + f Pay off long put = K - ST - f Pay off short put = ST – K + f 30

Example: Bear Spread Using Calls 31

Bear Spread Using Calls Option ST Position short call $45 Long call $45 Strategy cost Strategy Pay off K $40 $50 f (premium, Net Pay price, value) off $3. 1 - $1. 9 -$2. 9 3. 1 -2. 9=$0. 2 -$4. 8 Investor will buy a put option with strike price $50 by paying option price of $2. 0 and sell a put option with strike price $40 by receiving an option price of $1. 5.

Example: Bear Spread Using Puts 33

Bear Spread Using Puts Option ST Position short put $33 Long put $33 Strategy cost Strategy Pay off K $25 $29 f (premium, Net Pay price, value) off $2. 15 -$4. 75 +2. 15 -4. 75= -$2. 60 Investor will buy a put option with strike price $29 by paying option price of $4. 75 and sell a put option with strike price $25 by receiving an option price of $2. 15.

General Questions about a Strategy. 1. Name of The Strategy. Box Spread 2. In what situation The Strategy is used? If an investor wants to eliminate the risk of where the prices of the underlying asset close, he constructs the box spread. 3. How many positions The Strategy involves? 4 options 1. What are the long and short positions in The Strategy ? Long call, short call, long put, short put. 1. Drawing the graph of The Strategy. 2. On the basis of given data, calculating the payoff and net gains/losses of The Strategy. 3. Drawbacks of The Strategy. 35

Box Spread • A combination of a bull call spread and a bear put spread • If all options are European a box spread is worth the present value of the difference between the strike prices. • If they are American this is not necessarily so (see Business Snapshot 11. 1) 36

Box Spread using bull and bear 37

Box Spread 1. Construct the box spread and draw the graph. 2. Compute strategy pay off when spot price of underlying asset is $102. 38

Box Spread Option ST Position Long Call 102 Short Call 102 Long Put 102 Short Put 102 Strategy cost Strategy Pay off K 85 100 85 f (premium, Net Pay price, value) off -9. 17 7. 83 0. 31 -1. 69 - 6. 42 -6. 42 0. 30

Butterfly Spread Using Calls 40

Butterfly Spread Using Calls • Construct a butterfly spread using calls? • Compute pay off of butterfly spread if sport price is $64? 41

Butterfly Spread Using Calls Option ST Position Long Call 64 Short Call 64 Long Call 64 Strategy cost Strategy Pay off K 55 60 60 65 f (premium, Net Pay price, value) off -10 7 7 -5

General Questions about a Strategy. 1. Name of The Strategy. Butterfly Spread 2. In what situation The Strategy is used? When investor do not expect big changes in prices. 3. How many positions The Strategy involves? Four 4. What are the long and short positions in The Strategy ? Two long (lowest and highest premium) and two short positions (middle premium) 5. Drawing the graph of The Strategy. 6. On the basis of given data, calculating the payoff and net gains/losses of The Strategy. 7. Drawbacks of The Strategy fails when there are large movements in the prices of underlying asset. 43

Butterfly Spread Using Calls 44

Example: Butterfly Spread • Can we construct the butterfly spread from following data? Why or why not? • No because S 2 – S 1 ≠ S 3 – S 2 45

Example: Butterfly Spread • Can we construct the butterfly spread from following data? Why or why not? • If you can construct butterfly spread, what will be the pay off of the strategy if spot price is $31? 46

Butterfly Spread Using Puts Yes, because S 2 – S 1 = S 3 – S 2 Option ST Position Long Call 31 Short Call 31 Long Call 31 Strategy cost Strategy Pay off K 20 25 25 30 f (premium, Net Pay price, value) off -0. 5 0. 8 -1. 0

Calendar Spread: Self Study Calendar Spread Using Calls Calendar Spread Using Puts 48

General Questions about a Strategy. 1. Name of The Strategy. Straddle 2. In what situation The Strategy is used? When investor expects big movements in the prices of underlying asset and does not know the direction of the movement. 3. How many positions The Strategy involves? 2 options 1. What are the long and short positions in The Strategy ? Long call, long put. Drawing the graph of The Strategy. 1. On the basis of given data, calculating the payoff and net gains/losses of The Strategy. 2. Drawbacks of The Strategy. 49

A Straddle Combination Profit 1. Same Strike 2. Same Maturity K ST 50

Example 1: Straddle A put with strike price of $60 costs $6. A call with the same strike price and expiration date costs $4. 1. What will be cost of straddle? 2. What is the payoff from the straddle if spot price at expiry is $65? Option ST Position Long Call 65 Long Put 65 Strategy cost Strategy Pay off K 60 60 f (premium, Net Pay price, value) off -4 1 -6 -6 -4 -6=-10 -5 51

Example 2: Straddle A put with strike price of $60 costs $6. A call with the same strike price and expiration date costs $4. 1. What will be cost of straddle? 2. What is the payoff from the straddle if spot price at expiry is $80? Option ST Position Long Call 80 Long Put 80 Strategy cost Strategy Pay off K 60 60 f (premium, Net Pay price, value) off -4 16 -6 -6 -4 -6=-10 10 52

Example 3: Straddle A put with strike price of $60 costs $6. A call with the same strike price and expiration date costs $4. 1. What will be cost of straddle? 2. What is the payoff from the straddle if spot price at expiry is $65? Option ST Position Long Call 40 Long Put 40 Strategy cost Strategy Pay off K 60 60 f (premium, Net Pay price, value) off -4 -4 -6 14 -4 -6=-10 10 53

General Questions about a Strategy. 1. Name of The Strategy. Strangle 2. In what situation The Strategy is used? When investor expects very large movements in the prices of underlying asset and does not know the direction of the movement. 3. How many positions The Strategy involves? Two options 4. What are the long and short positions in The Strategy ? Long call, long put 5. Drawing the graph of The Strategy. 6. On the basis of given data, calculating the payoff and net gains/losses of The Strategy. 7. Drawbacks of The Strategy. 54

A Strangle Combination Profit 1. Same Maturity 2. Different strikes K 1 K 2 ST 55

Example: Strangle A put with strike price of $60 costs $4. A call with the strike price $70 and with same expiration date costs $2. 5. 1. What will be cost of strangle? 2. What is the payoff from the straddle if spot price at expiry is $90? Option ST Position Long Call 90 Long Put 90 Strategy cost Strategy Pay off K 70 60 f (premium, Net Pay price, value) off -2. 5 17. 5 -4 -4 -4 -2. 5= -6. 5 13. 5 56

Example: Strangle A put with strike price of $60 costs $4. A call with the strike price $70 and with same expiration date costs $2. 5. 1. What will be cost of strangle? 2. What is the payoff from the straddle if spot price at expiry is $15? Option ST Position Long Call 15 Long Put 15 Strategy cost Strategy Pay off K 70 60 f (premium, Net Pay price, value) off -2. 5 -4 41 -4 -2. 5= -6. 5 38. 5 57

Example: Strangle A call with strike price of $60 costs $3. A put with strike price $40 and same expiration date costs $4. 1. What will be cost of strangle? 2. What is the payoff from the strangle if spot price at expiry is $65? Option ST Position Long Call 65 Long Put 65 Strategy cost Strategy Pay off K 60 40 f (premium, Net Pay price, value) off -3 -4 58

Straddle vs Strangle. Profit K ST 59

Strip All are European Options. When investor knows there is going to be a large movement but believes price decrease is more likely Price decrease is steeper Call premium is higher 3 options 2 put 1 call Investor bet for Big price movements. stock price decrease is more likely than increase. 60

Strap All are European Options. Price increase is steeper Call premium is the highest 3 options 2 calls 1 put Investor bet for Big price movements. stock price increase is more likely than decrease. 61

Strip & Strap Figure 11. 11, page 267 All are European Options. Profit One long call Two long put K Strip ST Two long calls One long put K ST Strap 62

Other Payoff Patterns • When the strike prices are close together a butterfly spread provides a payoff consisting of a small “spike” • If options with all strike prices were available any payoff pattern could (at least approximately) be created by combining the spikes obtained from different butterfly spreads 63

Tips about Exam 1. Remember the formulae 2. Missing element of formula may be asked. Examples. 3. Info about strike/exercise price could be in the form of Table from where you will have to extract K. 4. There could be questions about Tables that you need to answer. 64