Trading Strategies Involving Options Chapter 11 Fundamentals of

Trading Strategies Involving Options Chapter 11 Fundamentals of Futures and Options Markets, 9 th Ed, Ch 11, Copyright © John C. Hull 2016 1

Strategies to be Considered l l Bond plus option to create principal protected note Stock plus option Two or more options of the same type (a spread) Two or more options of different types (a combination) Fundamentals of Futures and Options Markets, 9 th Ed, Ch 11, Copyright © John C. Hull 2016 2

Principal Protected Note l l Allows investor to take a risky position without risking any principal Example: $1000 instrument consisting of l l 3 -year zero-coupon bond with principal of $1000 3 -year at-the-money call option on a stock portfolio currently worth $1000 Fundamentals of Futures and Options Markets, 9 th Ed, Ch 11, Copyright © John C. Hull 2016 3

Principal Protected Notes continued l Viability depends on l l Level of dividends Level of interest rates Volatility of the portfolio Variations on standard product l l l Out of the money strike price Caps on investor return Knock outs, averaging features, etc Fundamentals of Futures and Options Markets, 9 th Ed, Ch 11, Copyright © John C. Hull 2016 4

Positions in an Option & the Underlying (Figure 11. 1, page 252) Profit K K ST ST (a) Profit (b) K ST (c) K ST (d) Fundamentals of Futures and Options Markets, 9 th Ed, Ch 11, Copyright © John C. Hull 2016 5

Bull Spread Using Calls (Figure 11. 2, page 253) Profit ST K 1 K 2 Fundamentals of Futures and Options Markets, 9 th Ed, Ch 11, Copyright © John C. Hull 2016 6

Bull Spread Using Puts Figure 11. 3, page 254 Profit K 1 K 2 ST Fundamentals of Futures and Options Markets, 9 th Ed, Ch 11, Copyright © John C. Hull 2016 7

Bear Spread Using Puts Figure 11. 4, page 255 Profit K 1 K 2 ST Fundamentals of Futures and Options Markets, 9 th Ed, Ch 11, Copyright © John C. Hull 2016 8

Bear Spread Using Calls Figure 11. 5, page 256 Profit K 1 K 2 ST Fundamentals of Futures and Options Markets, 9 th Ed, Ch 11, Copyright © John C. Hull 2016 9

Box Spread l l l 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) Fundamentals of Futures and Options Markets, 9 th Ed, Ch 11, Copyright © John C. Hull 2016 10

Butterfly Spread Using Calls Figure 11. 6, page 258 Profit K 1 K 2 K 3 ST Fundamentals of Futures and Options Markets, 9 th Ed, Ch 11, Copyright © John C. Hull 2016 11

Butterfly Spread Using Puts Figure 11. 7, page 259 Profit K 1 K 2 K 3 ST Fundamentals of Futures and Options Markets, 9 th Ed, Ch 11, Copyright © John C. Hull 2016 12

Calendar Spread Using Calls Figure 11. 8, page 260 Profit ST K Fundamentals of Futures and Options Markets, 9 th Ed, Ch 11, Copyright © John C. Hull 2016 13

Calendar Spread Using Puts Figure 11. 9, page 260 Profit ST K Fundamentals of Futures and Options Markets, 9 th Ed, Ch 11, Copyright © John C. Hull 2016 14

A Straddle Combination Figure 11. 10, page 261 Profit K ST Fundamentals of Futures and Options Markets, 9 th Ed, Ch 11, Copyright © John C. Hull 2016 15

Strip & Strap Figure 11. 11, page 262 Profit K Strip ST K ST Strap Fundamentals of Futures and Options Markets, 9 th Ed, Ch 11, Copyright © John C. Hull 2016 16

A Strangle Combination Figure 11. 12, page 263 Profit K 1 K 2 ST Fundamentals of Futures and Options Markets, 9 th Ed, Ch 11, Copyright © John C. Hull 2016 17

Other Payoff Patterns l l 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 Fundamentals of Futures and Options Markets, 9 th Ed, Ch 11, Copyright © John C. Hull 2016 18